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The Global Credit Crisis and China’s Exchange Rate Ronald McKinnon Brian Lee Yi David Wang Stanford University Singapore Economic Review Conference August 6-8, 2009 Advantages of Stabilizing Yuan/Dollar Rate A Potted History • 1995 to 2004 fixed rate nominal anchor: 8.28 Y/$ [McKinnon & Schnabl, Jan 2009] • • • July 2005 to July 2008, one-way bet on RMB appreciation: hot money inflows, buildup of official exchange reserves, loss of monetary control, disrupt forward exchange market [Wang 2009] July 2008 to Nov. 2008, unwinding of dollar carry trade with sharp apprec.of $ effective ex rate, (Lee 2009), Y/$ rate reset at 6.83 through to present 2009, monetary control regained with a massive expansion of bank credit to support fiscal stimulus for offsetting sharp fall in exports Figure 1: China’s monetary policy and the yuan/dollar rate (1995-2009) Yuan/Dollar 9.00 8.28 8.50 8.00 7.50 Fixed exchange rate anchor: monetary stability 6.83 7.00 One-way bet on yuan appreciation: loss of monetary control, inflation 6.50 "Accidental" stabilization: regain monetary control 6.00 5.50 5.00 95/Jun 96/Jun Source: FRB 04/Jun 05/Jun 06/Jun 07/Jun 08/Jun 09/Jun Figure 2: Foreign Reserves of China, Japan, Germany, and U.S. (2002-2009) 10,000 billion dollars (log scale) China Japan Germany United States 1.95 Tr 1,000 100 10 2002 2003 2004 2005 2006 2007 2008 2009 /Q1 Source: IMF and The People’s Bank of China Figure 6: Bilateral Trade Balances of Japan and China versus the United States (percent of U.S. GDP, 1955 – 2008/1) 3.0 Japan Bashing Japan China Japan+China 2.5 China Bashing 2.0 1.5 1.0 0.5 0.0 1955 1960 1965 1970 -0.5 Source: Kenichi Ohno, BEA 1975 1980 1985 1990 1995 2000 2005 2008/Q1 U.S Mercantile Pressure, I. • Acute Japan Bashing, 1978 to 1995 - Episodic trade disputes steel, autos, color televisions, machine tools, semi conductors - Resolution: Japan imposes “voluntary” export restraints and allows yen appreciation -Yen/dollar rate appreciates episodically from 360 in August 1971 to peak at 80 in April 1995, when U.S. announced a strong dollar policy • Japan financial system destabilized: bubble economy 1987-90 followed by a deflationary slump and low interest liquidity trap in 1990s (McKinnon-Ohno,1997) U.S. Mercantile Pressure, II. • China Bashing: 2000 to ? -China surpasses Japan in 2000 as having the biggest bilateral trade surplus with the U.S -Unlike Japan, export surge is “across the board” in low value added manufactures. • Focus is primarily on appreciating the Renminbi: -Schumer-Graham bill of March 2005 for a 27.5% tariff on U.S. imports from China unless RMB appreciates (withdrawn October 2006, but new threat in 2007) -Section 3004 of U.S. Public Law 100-418: U.S. Secretary of Treasury must report twice a year on whether countries with trade surpluses are “manipulating” their currencies. Timothy Geitner’s congressional testimony January 2009 • RMB rises by 2.1% on July 21 2005, and begins slow upward crawl One way bet: RMB appreciation July 2005 to July 2008 • • • • • • Hot money flows into China No private capital outflows to finance China’s huge trade surplus (McK & Sch 2009) Huge buildup of official exchange reserves: government sole international intermediary Massive sterilization: sale of central bank bonds, increases in reserve requirements of com banks Direct restraints on domestic bank credit Still loss of monetary control with domestic inflationary pressure added to foreign China’s Foreign Exchange Reserves Source: UBS Figure 3: China’s Consumer Price Indices (Growth rate: % yoy) 10 8 6 4 2 0 2002 2003 -2 -4 Source: EIU 2004 2005 2006 2007 2008 2009 Figure 4: Renminbi and Dollar Exchange Rate Movements (2000-2008) 120 Unwinding of Carry Trades 115 110 105 100 July2008 95 90 85 2000 2002 2004 2006 Nominal Rate Dollar Yuan Effective Rate of the Renminbi Effective Rate of the U.S. dollar Source: IFS and BIS 2008 Figure 5: Commodity Price Indices (Jan 2002 =100) 750 700 650 600 550 The Economist Commodity-Price Index West Texas Intermediate 500 450 400 350 300 250 200 150 100 50 2002 2003 2004 2005 Source: globalfinancialdata.com 2006 2007 2008 2009/05 Figure 8: Unwinding the yen and dollar carry trades (effective exchange rates, 2006=100) 130 120 110 July 2008 100 90 2000 2002 2004 United States Japan Source: BIS 2006 2008 Table 1: Returns on carry trades (2000-2007) Funding Currency Interest rates Funding Investment Returns from Returns of Appreciation Carry trades US Dollar 3.4 10.2 a 1.1 a Japanese Yen 0.1 5.3 b 5.2 b Unwinding in 2008: c Trough to Peak Appreciations a 7.9 19% 10.7 b Source: Brian Lee (2009) Note: (a) For funding in dollars, the return is the average for Brazil, Mexico, and Canada. (b) For funding in yen, the return is the average for Australia, Korea, and New Zealand. (c) Trough to peak for the yen’s effective multilateral exchange rate. Caution: The unwinding of the carry trades in 2008 may not fully explain these exchange rate appreciations. 44% Dollar carry trade unwinds and “accidental” stabilization of the RMB since July 2008 • Credit crunch summer and fall of 2008 dries up short-term • • • • • finance for dollar, yen, and commodity carry trades Surprise dollar appreciation, July to Nov 2008, of approx 20% against all currencies except the Japanese yen with a general fall in commodity prices. PBC stops gradual (and predictable) appreciation of RMB, and stabilizes at 6.83 yuan/dollar. Hot money inflows stop, some private outflows, minimal increases in official exchange reserves. PBC regains monetary control Massive domestic credit expansion: cuts in reserves required of commercial banks while lifting credit ceilings, reductions in deposit and loan interest rates Domestic spending largely offsets collapse in exports Figure 9: China’s Nominal Trade (in billions of U.S. dollar, monthly) 160 Exports 140 Imports 120 100 80 60 40 20 2005 2006 2007 2008 Source: China Customs Statistics Information 2009 /04 Figure 10: China’s interest rates (%) Source: UBS Figure 11: China’s New loans to non-financial institutions (RMB bn) Source: UBS Figure 12: China’s M2 and Bank Lending (Growth rate: % yoy) Source: UBS Loans for 15 large U.S. banks Comerica Marshall & Ilsley Wells Fargo Fifth Third SunTrust Regions Citigroup Bank of America US Bancorp PNC BB&T KeyCorp J.P. Morgan Chase Amercian Express Capital One 2Q 2009 in billions 46.60 48.60 821.60 81.40 122.80 96.20 641.70 942.20 182.30 165.00 100.30 70.80 680.60 62.90 146.30 Change from 1Q -4.1% -1.8% -2.6% -1.5% -0.9% 0.5% -2.4% -3.6% -1.1% -3.7% 0.1% -3.9% -3.9% -3.2% -2.7% 4,209.30 -2.80% Total for 15 banks Source: Wall Street Journal M2 growth around the world Source: SCB Violation of interest parity conditions and breakdown of China’s forward market mid 2007 to mid 2008 • Open Interest Parity (OIP): E(∆S) = it(yuan) – it(dollars) , where S = yuan/dollar • Covered Interest Parity (CIP): ft = it(yuan) – it(dollars) where f = (F – S)/S is forward premium on dollars OIP breaks down when the interest differential is less than expected appreciation because of fall in US rates CIP breaks down when SAFE had to impose controls on financial capital inflows, i.e., borrowing in dollars • Result: China’s exporters can’t cover dollar earnings forward, thus tightening credit constraint Figure 13: Interest Differentials versus Percentage Changes in the Yuan/Dollar Exchange Rate (2002-2009) 6 4 2 0 -2 Exchange rate stabilization 8.28 yuan/dollar Accidental stabilization 6.83 yuan/$ -4 -6 Yuan/Dollar Change (yoy) -8 Interest Differential Fed Funds Rate -10 -12 2002 China overnight 2003 2004 Source: Datastream. Note: OIP is Open Interest Parity. OIP holds 2005 2006 2007 OIP OIP fails Restored 2008 July 2009 09/5 Figure 14: Forward Rate vs. Forward Rate from Covered Interest Parity (yuan/dollar,6 month) 8.0 7.8 7.6 7.4 7.2 7.0 6.8 6.6 6.4 Outright Forward 6.2 Implied Forward 6.0 Oct-08 Dec-29 Apr-04 Jul-05 Sep-27 Dec-27 Mar-31 Jun-27 Sep-22 Dec-22 Mar-26 06 07 Source: Wang (2009) 08 09 Jun Figure 15: Percentage Deviation From Covered Interest Parity (yuan/dollar, by maturity) 2% 0% -2% -4% -6% 6 Month 3 Month 9 Month -8% -10% Oct-08 Dec-29 Apr-04 Jul-05 Sep-27 Dec-27 Mar-31 Jun-27 Sep-22 Dec-22 Mar-26 06 07 Source: Wang (2009) 08 09 Jun Reducing China’s Saving-Investment Surplus Increase share of household disposable income in GDP in order to increase private consumption • • • • reduce personal income and sales taxes increase government transfer payments increase dividend payouts from enterprises Increase government social expenditures. Stimulate household spending • increase consumer credit • abolish one-child policy? Objectives (1) Reduce China’s trade surplus (2) Counter cyclical downturn in China and rest of the world • Caveat: Stabilize exchange rate (Mundell-Fleming) Figure 16: Investment, Savings and Current Account of China (as a percent of GDP) 60 Investment Savings 50 Current Account Surplus 40 30 20 10 0 2000 2001 Source: EIU 2002 2003 2004 2005 2006 2007 2008 Figure 17: China’s Labor Income and Operating Surplus (Share in GDP(%)) Source: UBS Table 2: China’s Economic Positions in 1997 and 2007 Source: UBS Note: The NPL ratio is 2.8% for four largest commercial banks, Dec 2008. Conclusion:Countering the Global Cyclical Downturn in 2008-09 • New U.S. fiscal stimulus is problematic: weak domestic financial institutions, and trade deficit would increase • China now a big actor on the world stage with stronger public finances and much stronger banking system • To stimulate the U.S. and world economies, the primary fiscal stimulus should be in China and other surplus Asian economies—and possibly Germany. • Nov 2008, China announces a half trillion dollar fiscal stimulus—now supported by rapid bank credit expansion • U.S. quid pro quo: No more China bashing on exchange rate, or through antidumping duties, and other policies